Ebook How do contracts adapt to an increase in free cash flow?
In this paper, I examine the evolution of firm contracts as the firm’s environment changes. While there has been extensive cross-sectional research documenting associations between contract choices (financing, monitoring, and compensation policies) and economic determinants, there is much less work corroborating these results with evidence that firms adapt to changes in their environment. I contribute to the literature on contracting by examining three research questions. First, I examine if contracts change in a manner predicted by economic theory in the years surrounding a change in the firm’s environment. Second, I study whether firms that can anticipate the change in the firm’s environment adjust contracts differently. Finally, I examine if the changes in contracts are associated with different managerial actions.
To address these research questions, I select a sample of firms that provides a powerful setting to study how contracts adapt to a change in the firm’s environment. I focus on firms experiencing a large and persistent increase in internally generated cash flow in excess of available investment opportunities (free cash flow). Multiple theories predict that an increase in free cash flow is an important event in the life of the firm affecting various firm contracts. Theories based on agency costs suggest that an increase in free cash flow provides managers with additional opportunities to engage in wasteful expenditures unless the appropriate contracts are present (e.g., Jensen, 1986; Lamont, 1997; and Titman, Wei and Xie, 2003). Theories based on market imperfections suggest that if it is costly to write contracts with external capital providers (due to information asymmetry) then an increase in internally generated cash flow will be associated with a concurrent increase in the feasible investment opportunity set (e.g., Fazzari, Hubbard, and Petersen, 1988).
My aim in this paper is to enrich our understanding of how a firm adapts to a significant change in its economic environment. For my sample of 270 firms, I examine several aspects of this change. First, do the contracts between various stakeholders change in response to the new level of free cash flow? For example, do the contracts between shareholders and management change in a manner consistent with the emergence of a new agency problem (e.g., increase in monitoring or equity incentives) or are contracts with external capital providers structured so that the firm can borrow when cash flow is low and repay these funds when cash flow is high? Second, do firms that are better able to predict the change in free cash flow adapt differently or more quickly to the change? Third, do the changes in contracts affect what a firm does with the free cash flow (i.e., do they distribute the free cash flow to external capital providers or do they retain the cash internally)?
Overall, when examining my three research questions I find evidence that contracts between the firm and external capital providers are consistent with theories based on market imperfections. Firms that receive cash from debtholders before an increase in cash flow begin to repay their debts when cash flow increases. In addition, the ability to raise capital before the increase in cash flow occurs is associated with the ability to predict the increase in cash flow.
Finally, the firms that are able to borrow are able to finance more investment before the increase in cash flow and do not increase investment when the increase in cash flow occurs. However, I find little evidence that contracts change to control the agency costs associated with free cash flow. For the average sample firm, there are few changes to contracts designed to limit over investment. In addition, the firms that expect an increase in cash flow do not change contracts more quickly than the firms that are surprised. Finally, there is little evidence that the firms that do not increase over-investment change contracts differently than other firms.
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